Strategic Compensation Pays Off

As the bull market continued throughout 1997, so did the financial success of real estate firms across many market segments. Ongoing consolidation has resulted in larger, more complex organizations with highly demanding compensation arrangements. Companies that successfully adapted to the environment of the late 1990s continuously monitored their compensation plans, while those that were slow to react risked losing key players.

For the most part, the retail industry has not achieved significant performance levels over the past five years. As in the past, 1998 initiates concerns for many retailers and the shopping centers that house them. There is continued space saturation in many regions of the United States, and consumers are still leery of spending despite the upward economy and decreased unemployment rate.

Still, it is inaccurate to say that in 1996 and 1997 the entire retail industry suffered. Some retailers experienced a decline in sales, while others realized moderate to significant sales growth.

Some realty companies are performing well because of their alliance with successful retailers. For example, Colonial Properties Trust experienced a 10 percent climb in FFO from 1996 to 1997. JDN Realty, Price REIT and Prime Retail each posted fourth-quarter results in 1997 that were dramatically increased from the year before.

Another indicator of performance is the degree to which companies are buying and/or developing property. The first quarter of 1998 has seen a number of significant property acquisitions.

Kimco purchased eight shopping centers in the Denver area, three in Chicago and one in Detroit. Westfield America purchased the 1 million sq. ft. Crestwood Plaza in Crestwood, Mo.

New development projects are also on the rise. Simon DeBartolo Group announced plans to renovate an existing mall in Orlando and add 600,000 sq. ft. of GLA. Also, The Rouse Co. developed the site for the 250,000 sq. ft. Nordstrom department store at Perimeter Mall in Atlanta.

Some people worry that additional development will cause further space saturation. However, many areas in the United States still have significant demand for new shopping centers. Hollywood, Calif., and downtown Manhattan are seeing a resurgence of retail development because of increased residential development during the past 18 months.

Numerous consolidations have occurred in 1997 and early 1998. By consolidating, small and mid-sized companies can capitalize on enhanced economies of scale and make better use of capital and personnel. Among the recent consolidations: Kimco is set to acquire Price; and Regency Realty has agreed to acquire The Midland Group, the largest developer of Kroger-anchored centers in the United States.

To draw consumers into malls and strip centers, shopping center owners and developers are using various strategies, including theme restaurants, children's zones, specialty stores and movie theaters. Malls and strip centers are becoming entertainment centers, one-stop shopping sources for merchandise, food and fun. Outlet centers are adding higher-profile stores and altering their exteriors and landscaping in an attempt to be perceived as more upscale. At the same time, Wal-Mart and other discount stores continue to be successful in their strategy of simplicity and affordability.

If efforts to strengthen the retail industry are to be effective, organizations must hire, reward and retain the appropriate personnel. In a market that requires flexibility, innovation and fortitude, a company must leverage pay properly in order to motivate employees to work toward company-wide goals while meeting incumbents' compensation expectations.

For most positions, base salaries have not increased dramatically from 1997 to 1998. Increases ranged from 3 percent to 9 percent for most positions. However, base pay rose more dramatically for a handful of other jobs. For example, the market competitive base salary for director of construction was $97,520 in 1997 but has risen to $118,000 in 1998. The 22 percent increase for this position most likely stems from expanded interest in new shopping center sites. Also, this position had not been of primary focus in 1997 due to the space saturation of the past several years.

Other positions with sizable increases in base compensation are the regional head/senior leasing representative and the regional head/senior property manager, possibly because of the hierarchical structure of companies. Instead of having one national director of a particular function, many firms subdivide responsibilities so that an individual is in charge of a region, state or city.

These individuals are earning more because they have greater responsibility, given the increase in construction and renovation activity. Also, they must manage and satisfy more complex retailers and entertainment vendors.

Annual incentives Table 2 illustrates the total annual compensation for the 21 positions included in the study conducted by FPL Associates. Total annual compensation is defined as the sum of the base salary plus annual incentive plus commission (for those positions eligible to receive commission). Annual incentives continue to be the primary vehicle for motivating and rewarding employees.

Bonus awards in the retail sector are competitive within the larger context of the real estate industry, even though retail performance may be dwarfed by other segment results. For example, real estate companies focusing on office property performed better but had similar bonuses.

Perhaps the limited consumer dollar, overpopulation of stores and overabundance of space have altered the context in which retail performance is measured, so that consistent returns and/or moderate growth are considered good rather than just average. Table 3 illustrates shopping center owners' and managers' perceptions of performance in 1997.

In addition, compensation packages for some positions are structured to reward maximum results. For example, in leasing and property operations, pay is usually leveraged so that the annual bonus and/or commission is the largest component of compensation, with a relatively modest base salary.

Some firms include all positions in the annual incentive plan, while a select few maintain a commission plan. Seventy-five percent of study participants allow leasing and operations personnel to participate in both a commission-based program and an annual incentive plan.

In those situations, very specific and challenging goals are associated with the commission schedule. Leasing personnel are often required to lease a certain amount of square footage, lease to a specified mix of vendors or sign special lease agreements. Payouts to leasing personnel under annual plans are often determined by the company's overall performance.

Table 4 displays the range of potential incentive opportunity as a percentage of base salary for both target and maximum levels of performance. Target represents the incentive possible for solid performance, while maximum represents a more significant achievement.

Pay for performance The retail industry is always searching for better ways to link compensation to performance. Commission plans are prime examples of retail's desire to motivate people toward achieving very specific, pre-set goals.

A more expansive effort to link pay and performance is termed "pay-for-performance." This is typically the predominating philosophy underlying a company's annual incentive plan.

In this arrangement, a portion of the bonus is allocated to various dimensions of performance, including performance of the company, the functional unit and the individual. The importance of each of these performance dimensions varies according to the level of the position.

For example, a senior executive would have a substantial portion of his annual incentive determined by corporate performance. A mid-level or front-line manager would have most of the bonus determined by functional unit or individual performance.

The allocation should reflect the primary focus of the position as well as the individual's ability to influence each dimension.

Using a pay-for-performance structure requires that performance measures and standards are developed and communicated for each performance dimension. Table 5 lists examples of common performance measures.

Employment contracts During the past four to five years, the real estate industry has gone through numerous phases in the use of employment contracts.

Prior to the onslaught of merger activity was the "we are all honorable men" period, characterized by handshake agreements. Most executives were in fact employees at will. Contracts during this period tended to be highly focused on partnership agreements or equity participation. Public companies adopted fairly minimal option agreements or letters of understanding.

Documentation was normally one-sided, typically prepared by the employer and signed by the executive. Relatively little negotiation took place. The employer-employee relationship was built on the assumption that the principle of the firm could control the future of the company, as well as the future career paths and economic well-being of its executives.

The "honorable man" period came to an end with the attempted unfriendly acquisition of Chateau Properties by Sam Zell's Manufactured Homes. This was a leading-edge event that impactedall of commercial real estate, including retail.

The Chateau Properties Management team had operated for 20 years, including the last three as a public company, under the "honorable man" relationship. The attempted takeover by Zell made many real estate executives realize that their future may not be entirely within their, or their company's, control.

Since the Chateau transaction, real estate firms have raced to their boards with employment contracts. FPL Associates estimates that 60 percent to 65 percent of public real estate firms have adopted employment agreements for executives and senior management.

Spill-over from the public markets also can be seen within private real estate firms. Contracts here are not as detailed as those in public firms, but executives at private real estate firms are asking for and receiving agreements that address the most traditional issues.

The employment contract took its third incarnation following the merger of Columbus and Post Properties. FPL Associates believes that this merger caused employment agreements in public real estate firms to step up in comprehensiveness and complexity.

The issue at Columbus centered around the valuation of long-term incentives. Also at issue was the excise tax on "golden parachute" payments levied for exceeding the parameters established by the IRS.

To calculate excess parachutes, a base amount of compensation is defined that typically includes W-2 compensation. If compensation resulting from a change of control is more than three times the base amount, then that is considered an excess parachute.

In the years before the merger, the Columbus management team structured its entire compensation program around stock options and restricted stock. Salary and cash bonus awards were waived in favor of large option and restricted stock awards.

This plan provided little or no base compensation; therefore, all compensation resulting from the transaction was considered an excess parachute. Unfortunately, the employment agreements did not specify a method for valuing stock-based compensation in the event of a change of control.

The contracts were also silent on providing any assistance for payment of tax penalties. Future contracts will undoubtedly address these issues.

The current phase of employment contract development was introduced with the recent acquisition of ITT by Starwood. This merger questions the definition of a change of control and whether it should produce an economic windfall for the acquiring management team.

In the Starwood transaction, members of Starwood's management would have stock options vesting as a result of a technical change of control, but most of these executives remained employed in similar positions.

Adjusting to changeAs the real estate industry continues on its cyclical path, retail real estate companies must adjust to changing demands. Attracting, motivating and retaining high-caliber executive talent is critical to a company's ability to adapt.

The key to addressing this human resources issue is establishing flexible compensation plans, with such components as performance-based incentive plans and employment agreements. Companies that stay abreast of industry compensation trends will be better prepared to compete in this ever-changing environment.

The following summary presents typical parameters of employment contracts: * The number of executives with employment agreements ranges from one to nine, with the typical number being four.

* The typical length of the contract is three years, with some leading-edge companies adopting five-year terms. Stability of executives, tenure, career planning and management succession should be considered when evaluating a five-year term.

Many public real estate firms provide for an automatic renewal of one year at the end of the contract. Automatic renewals are often evergreen types of renewals: The contract continues to renew for one year until written notice of termination of the agreement is provided or until a new contract is drafted.

* A non-compete provision is a quid pro quo for providing the executive with an employment agreement. The duration of the non-compete period is usually one to three years, with one year the most common.

Some companies are adopting non-compete provisions that vary with the amount of severance and the reason for the executive's separation. An executive terminated for cause would have no period of non-compete. In the case of a premature contract termination where the executive is paid for the balance of the contract term, the period of non-compete would last for the remainder of the contract term.

Employment agreements often include a multitude of provisions. The following is a "wish list" of provisions:

* Definition of a change of control

* Specification of what triggers the employment contract to be enacted

* Salary continuation (one to three years)

* Specification of how to calculate annual bonus if there is a change of control - for example, corporate performance based on an average of the past three years; corporate performance forecast for the current year; or one to three times the amount of the last bonus